The Federal Communications Commission has requested comments on the regulation of voice telephone services delivered over the Internet, dubbed "VoIP" or Voice over Internet Protocol. This paper examines whether there is a need to regulate VoIP. We conclude that there is no economic rationale for regulating VoIP and that consumers will likely be worse off if VoIP is regulated. Furthermore, the emergence of new technologies, such as VoIP, is rapidly eroding the rationale for continuing to regulate local telephone services.

Crandall, Robert W.

Hahn, Robert W.

Litan, Robert E.

Wallsten, Scott

English

Research Papers in Economics

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The attached material is posted on regulation2point0.org with permission.  
JOINT CENTER  
AEI-BROOKINGS JOINT CENTER FOR REGULATORY STUDIES 
 
 
Internet Telephones: Hanging up on Regulation?  
 
 
Robert W. Crandall, Robert W. Hahn, Robert E. Litan, and Scott Wallsten
* 
 
Regulatory Analysis 03-12 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
This paper was published in the Milken Institute Review in 2004. 
 
An earlier version of this paper was published on December 2003 on the 
AEI-Brookings Joint Center website. 
                                                           
* Mr. Crandall, Mr. Hahn, Mr. Litan, and Mr. Wallsten are scholars at the AEI-Brookings Joint Center for 
Regulatory Studies. We would like to thank Shenyi Wu for research assistance. The views expressed in 
this paper reflect those of the authors and do not necessarily reflect the views of the institutions with 
which they are affiliated. 
  
  
 
J   O   I   N   T     C   E   N   T   E   R 
AEI-BROOKINGS JOINT CENTER FOR REGULATORY STUDIES 
 
 
In order to promote public understanding of the impact of regulations on 
consumers, business, and government, the American Enterprise Institute and the 
Brookings Institution established the AEI-Brookings Joint Center for Regulatory 
Studies.  The Joint Center’s primary purpose is to hold lawmakers and regulators 
more accountable by providing thoughtful, objective analysis of relevant laws and 
regulations. Over the past three decades, AEI and Brookings have generated an 
impressive body of research on regulation. The Joint Center builds on this solid 
foundation, evaluating the economic impact of laws and regulations and offering 
constructive suggestions for reforms to enhance productivity and welfare. The 
views expressed in Joint Center publications are those of the authors and do not 
necessarily reflect the views of the Joint Center. 
 
 
 ROBERT W. HAHN 
Executive Director 
  ROBERT E. LITAN 
Director 
 
 
COUNCIL OF ACADEMIC ADVISERS 
KENNETH J. ARROW 
Stanford University 
  MAUREEN L. CROPPER 
University of Maryland  
 PHILIP  K.  HOWARD 
Covington & Burling 
 
        
PAUL L. JOSKOW 
Massachusetts Institute 
of Technology 
 DONALD  KENNEDY 
Stanford University 
 ROGER  G.  NOLL 
Stanford University 
        
GILBERT S. OMENN 
University of Michigan 
 PETER  PASSELL 
Milken Institute 
 RICHARD  SCHMALENSEE 
Massachusetts Institute 
of Technology 
        
ROBERT N. STAVINS 
Harvard University 
 CASS  R.  SUNSTEIN 
University of Chicago 
  W. KIP VISCUSI 
Harvard University 
 
All AEI-Brookings Joint Center publications can be found at www.aei-brookings.org 
 
© 2004 by the authors.  All rights reserved. 
Executive Summary 
 
  The Federal Communications Commission has requested comments on the regulation of 
voice telephone services delivered over the Internet, dubbed "VoIP" or Voice over Internet 
Protocol. This paper examines whether there is a need to regulate VoIP. We conclude that there 
is no economic rationale for regulating VoIP and that consumers will likely be worse off if VoIP 
is regulated. Furthermore, the emergence of new technologies, such as VoIP, is rapidly eroding 
the rationale for continuing to regulate local telephone services. 
 30 The Milken Institute Review
InternetT
31 Third Quarter  2004 
The ﬁ  rst half of 2004 saw a ﬂ  urry of activity involving ordinary voice telephone 
service delivered over the Internet – the technology known as Voice over Internet 
Protocol, or simply VoIP. Indeed, as of April, one company (Vonage) had signed up 
more than 100,000 VoIP customers. Vonage’s success has attracted the attention of 
AT&T, Verizon, Qwest and the cable companies, which are all racing to offer VoIP 
across the country. 
The wild card in this birth of a new industry is the response of the 
telecommunications regulators, who have been promoting local phone 
competition under a mandate from Congress for the past eight years while 
simultaneously distorting free-market outcomes by subsidizing various 
telecom constituencies. Because the subsidies are funded through taxes on 
traditional telephone service, Internet telephony threatens to reduce the 
revenues for such subsidies and may therefore represent more competition 
than regulators will tolerate. 
Policymakers are deeply divided on the issue. The chairman of the Fed-
eral Communications Commission, Michael Powell, has concluded that 
the burden of the argument for regulating VoIP “should be on those who want reg-
ulations extended.” Bills recently introduced by Republicans in both the House and 
Senate would bar states from regulating VoIP and would limit the types of regula-
tions the feds could impose on it. Meanwhile, the FCC is embroiled in a debate over 
how or whether to regulate VoIP, while state regulators, concerned about their abil-
ity to raise revenues through telecommunications taxes, are pushing for the right 
to regulate it.
A close look suggests there is no solid economic rationale for regulating VoIP at 
either the federal or state levels. In fact, the explosion of wireless telephone service, 
along with the emergence of new technologies like VoIP, erodes the economic ratio-
nale for regulating voice telephony of any form.
m
i
c
h
a
e
l
 
s
i
p
e
Hanging up on Regulation?
By 
Robert W. 
Crandall, 
Robert W. 
Hahn, 
Robert E. 
Litan 
and Scott 
Wallsten
Telephones32 The Milken Institute Review
dominant? who’s dominant?
For decades, the states and the FCC regulat-
ed telephones under the so-called dominant-
carrier standard. This was based on the prem-
ise that if a phone company dominates its 
market, i.e., if it has market power, consumers 
have to be protected from its ability to raise 
prices, deny service, or degrade quality. That’s 
why AT&T’s long distance service was regu-
lated until 1995, and why most of the Baby 
Bells’ local services are still regulated.
But the dominance these phone compa-
nies once enjoyed has been seriously eroded 
by both technology and new sources of com-
petititon. Cellular telephone service began in 
1983, eventually providing a large share of the 
country’s phone subscribers with at least one 
choice other than the local ﬁ  xed-wire compa-
ny. Long distance competition began in ear-
nest with the breakup of AT&T in 1984, along 
with the rapid growth of MCI, Sprint and 
later, WorldCom. A number of new carriers 
entered the market after the government auc-
tioned a large swath of new spectrum for cell 
service in 1996. And while most of the com-
petition has come from these new cellphone 
entrants, the 1996 Telecommunications Act 
also allowed a number of new telephone 
companies to provide local telephone service. 
Even some cable television companies began 
to offer telephone service after 1996.
Today, most consumers can buy telephone 
service from their traditional ﬁ  xed-wire car-
rier (generally a Baby Bell), one of six national 
cellular carriers, one of the three major long 
distance companies, one of the new entrants, 
or, in some places, their cable television pro-
viders. Each of these carriers offers a variety 
of local and long distance plans, along with 
bundles of local, long distance and other ser-
vices, like high-speed Internet access. There 
are now more than 148 million cellphone 
subscribers in the United States. And thanks 
to the large number of off-peak minutes 
available at no extra charge in many cellular 
packages, the average subscriber uses a cell-
phone more than a ﬁ  xed-line telephone. Thus, 
it is unclear that any carriers are “dominant” 
in offering telephone service. 
enter voip
Given this expanding array of choices and 
the competitive pressure placed on all tele-
phone services, revenues from non-wireless 
telephone are declining steadily. Consum-
ers can buy all the residential telephone ser-
vice they want – that is, unlimited local and 
long distance calling – for $50 per month or 
less. Why, then, would anyone want to offer 
voice calling over the Internet? Because it is a 
cheaper way to deliver the service.
VoIP is very inexpensive to provide because 
it is delivered by high-speed Internet. Simply 
by adding a relatively modest software pro-
gram to their computers or by plugging a 
small device into their Internet connections, 
consumers can have voice calls delivered over 
cable or digitally enhanced copper telephone 
wires to ordinary handsets located anywhere 
near a cable jack. Most of the cost of tradi-
tional telephone service is the local network’s 
delivery of the call. Once a call is switched 
from a local telephone company to a long dis-
tance carrier, it costs only a small fraction of a 
cent per minute to deliver it to another local 
telephone company – even if the call recipi-
ent is halfway around the world. If consum-
ers can avoid the costs of using the switching 
capacity of local networks, the cost of a call 
falls dramatically.
The authors are scholars at the American Enterprise 
Institute-Brookings Joint Center, which focuses on 
regulation and antitrust.
internet phone service33 Third Quarter  2004 
For years, VoIP was ignored by the mar-
ket because of its poor signal quality. The 
Internet was not designed to deliver real-time 
voice services. Delays in delivering the Inter-
net’s millions of tiny packets of data created 
interruptions and distortions. But these tech-
nical problems are being solved rapidly. 
In addition, as the number of households 
with always-on high-speed Internet service 
grows, the potential market for transmitting 
voice over the Internet grows with it. Today, 
about one household in ﬁ  ve operates in the 
Internet fast lane, and the number is expand-
ing rapidly.
The economics underlying VoIP are solid. 
VoIP can be delivered at a fraction of the 
price of the new unlimited bundled services, 
perhaps for as little as $20 per month. There-
fore, if the companies offering this service 
can identify households that have high-speed 
Internet connections and bring in new cus-
tomers at a cost of, say, $200 per household, 
they can expect to make money by offering 
the service at $30 or $35 a month if customers 
are reasonably loyal. No one knows wheth-
er consumers will ﬁ  nd the current quality of 
VoIP acceptable, but it is safe to say that tra-
ditional telephone companies and their regu-
lators are worried.
why regulate voip?
The market in which Internet telephony 
operates is already very competitive and will 
become even more competitive once VoIP 
joins the mainstream. Yet some state regula-
tors, led by Minnesota’s, have already tried to 
regulate VoIP, and the FCC has launched an 
inquiry into a parallel endeavor. No objec-
tive observer could conclude that these new 
companies are dominant in the delivery of 
telephony. As noted above, Vonage, the largest 
VoIP carrier, has about 100,000 subscribers, 
while wireless companies have 148 million 
subscribers and ﬁ  xed-wire telephone compa-
nies maintain 180 million subscriber lines. 
Unfortunately, though, telephone regula-
tion involves much more than efforts to limit 
market power. Indeed, regulators have been 
instructed by Congress and state legislatures 
to advance social agendas under the cover of 
dominant-carrier regulation. 
• They keep rural rates for access to the net-
work low by doling out beneﬁ  ts to rural 
carriers. 
• They make sure that the cost of a call on 
low-density routes is no higher than that 
for a call on dense routes, where the average 
overhead per call is much lower. 
• They subsidize low-income telephone sub-
scribers. 
• They tax telephone revenues to support 
communications services for schools, librar-
ies and rural health facilities. 
•  They encourage local competition by allow-
ing new (post-1996) companies to use the 
older, ﬁ   xed-line companies’ facilities at 
prices below the latter’s embedded costs. 
Aggressive competition from new services 
like VoIP threatens this entire superstructure 
of social policy disguised as monopoly regu-
lation, because it reduces the cash that regula-
tors can shift. 
the regulators’ dilemma
Regulators have no legislative authority to 
second-guess the rates set by the six national 
wireless carriers. As a result, these companies 
have been competing aggressively with ﬁ  xed-
wire telephone companies, taking away at 
least 30 percent of their long distance trafﬁ  c 
and perhaps 3 to 5 percent of their local sub-
scribers in the past four years. Cable compa-
nies are also largely unregulated, and, by no 
coincidence, have aggressively marketed new 
digital video services and broadband Internet 
access. Soon, however, every cable company 34 The Milken Institute Review
could become a major competitor in telepho-
ny, probably through VoIP. 
Can the regulators let them drive down 
telephone rates the way wireless companies 
have driven down long distance rates? If they 
do, they surely will have to deregulate the 
dominant local carriers and watch as compe-
tition aligns telephone rates with costs. 
The result would be an increase in ﬁ  xed-
line local residential charges in rural areas 
and a decline in the rates charged to virtually 
all others. It would also mean rapid erosion 
of the interstate revenue base, now used to 
subsidize low income households, high-cost 
rural telephone companies, schools, libraries 
and rural health facilities. 
a better policy? 
A variety of interests will probably want to 
bring VoIP under the regulatory tent. Com-
peting ﬁ   xed-wire carriers will surely argue 
that if they are regulated and taxed under the 
current regulatory framework, competitors 
offering VoIP should be subject to the same 
rules. The wireless carriers will fashion simi-
lar arguments for extending the regulatory 
taxes to VoIP because interstate wireless rev-
enues are currently taxed heavily (but not 
regulated). Others will contend that VoIP 
must be regulated so that it meets the same 
quality standards as other voice services, 
including emergency 911 service, standby 
power during electrical power failures, and 
access for wiretapping by police and national 
security authorities.
The argument against extending such reg-
ulation is more convincing. Jerry Hausman of 
MIT has estimated that taxes on interstate 
and international telephone revenues that are 
used to support low-income subscribers, 
high-cost carriers, schools, libraries and rural 
health facilities, are about three times more 
costly to the economy than the same sums 
would be if they were raised through general 
income or consumption taxes. If regulators 
were deprived of the ability to carry out these 
redistributive social policies because they 
could no longer contend that any carrier is 
dominant, telephone rates would decline sub-
stantially and consumers would beneﬁ  t enor-
mously – and probably by more than their 
estimated cost, because of the salutary effects 
on investment and innovation.
Such deregulation would free companies 
to invest in new technologies without the fear 
that regulators would expropriate the gains 
from successful innovation. So even if VoIP 
does not turn out to be a smashing success 
(which is certainly possible) some other tech-
nology that is faster, better and cheaper would 
be more likely to emerge.
If legislators want to continue to subsidize 
classes of carriers or consumers, they could 
fund the subsidies from other revenue sourc-
es at a far lower cost to the economy. Note 
that these subsidies would be on-budget – and 
therefore more visible to voters. Some might 
even ask if the subsidies are worth their cost. 
a final word
With the emergence of productive new tech-
nologies, the rationale for continuing to reg-
ulate local telephone service is rapidly disap-
pearing. But there will always be pressure to 
regulate, because the losers from new tech-
nologies have incentives to use the political 
process to limit their losses, while regulators 
and legislators are loath to give up the right 
to divvy up the spoils. As economists, we can 
only point out that the social costs of regu-
lating services like VoIP are likely to be sub-
stantial. The trick to getting rid of inefﬁ  cient 
regulation is making these costs sufﬁ  ciently 
visible to force politicians and regulators to 
pay attention to them. M
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